calculating income for determining maximum pension in S-Corp

[ShoeBox Taxes]

Taxpayer (TP) is 100% owner of an S-Corp.

TP takes a W-2 salary, usually significantly more than 60% of the net income of the corp. Many years it's closer to 90%. I've been bugging TP for years, pointing out the whole point of an S-Corp is that you don't have to pay self-employment tax on all of your earnings, but the TP doesn't listen.

This year, the business didn't do nearly as well as TP expected. TP took $99k in salary, but the Corp is showing a loss of $45k.

The problem is, TP made pension contributions around $19k.

From what I've read in IRS literature, pass-through income does not count toward the employee's income to determine that pension %. 

Does that mean losses also don't decrease the employee's income?

Because a part of me is thinking this PT is looking at excess contributions, because their income is only $54k, meaning the pension can't be more than ~ $10k.

But if the loss is not figured in, then 19k is less than 20% of $99k, so we're ok.

(And don't lecture me about why they kept paying themselves while the business was losing money ... I have already lectured the client about it.)

Thanks in advance!

[sjrcpa]

For S Corps, pension/SEP/SIMPLE contributions are based on W-2 wages only. The net income/loss matters not.

[TaxGuyBill · Accepted solution]

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@ShoeBox Taxes wrote:

TP takes a W-2 salary, usually significantly more than 60% of the net income of the corp. Many years it's closer to 90%. I've been bugging TP for years, pointing out the whole point of an S-Corp is that you don't have to pay self-employment tax on all of your earnings, but the TP doesn't listen.

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As a side note, the amount of "reasonable compensation" on the W-2 has little to do with the net income of the business and is not determined by a percentage of the net profit.

[BobKamman]

"As a side note, the amount of "reasonable compensation" on the W-2 has little to do with the net income of the business and is not determined by a percentage of the net profit."

Or so the IRS would have you believe.  

[ShoeBox Taxes]

Thanks, everyone.

And I think I accidentally "accepted as solution" the wrong one, oops.

Several sources on irs.gov (which means it's more authoritative than any investor's site, but I know it doesn't necessarily mean anything) say at least 40% of the net income of the S-Corp should be wages, but I've also seen much discussion that refutes that. The IRS notoriously shies away from defining what's "reasonable," for obvious reasons, but I do see that "40%" thrown about a lot. 

[abctax55]

"...Several sources on irs.gov ....... say at least 40% of the net"

Please provide a link to those *sources on irs.gov.

 Thanks

[qbteachmt]

"the whole point of an S-Corp is that you don't have to pay self-employment tax on all of your earnings"

Uh, not really. The point of forming a corporation is because it makes sense to incorporate, and to have that separate entity, and probably at least 3-5 other reasons, minimum, even when you are not misled into creating this entity type. The exact same amount of tax is paid, in that both the S Corp and the Sole Prop pay 15.3% discounted by the credit back for the half-share as a business expense. It's still his own pocket. That's a very narrow perspective, in other words, and probably the least useful reason.

"TP took $99k in salary, but the Corp is showing a loss of $45k."

"why they kept paying themselves while the business was losing money"

Obviously, funds were on hand and available.

The reasonable salary is based on work performed, and value of that work, and I've never seen this "40%" as guidance in anything other than this comment in this topic, for the first time. RCReports is a great resource, though.

"pass-through income does not count toward the employee's income to determine that pension %"

You can't throw out the generic word "pension." Is there a plan? What type of plan? How does this employee participate? What sort of account(s) does this person have?

"this PT is looking at excess contributions, because their income is only $54k"

Try thinking of this example: you hire a person and pay them $100k. Your entity has a $300k loss. What is your employee qualified to contribute to their "pension" plan, in your estimation?

[ShoeBox Taxes]

I had mused: <<the whole point of an S-Corp is that you don't have to pay self-employment tax on all of your earnings>>

To which qbteachmt replied: <<Uh, not really. The point of forming a corporation is because it makes sense to incorporate....>>

Good point. It is only one reason. I do remind my clients that they still have to pay the 15.3% on all earned income, whether it gets split up into employer's portion and employee's portion, or whether it's reported on Schedule SE. But my point stands: a single-owner S-Corp doesn't have to pay that 15.3% on 100% of their net income. They can pay themselves a salary that's less than their company's net income, pay SE taxes only on their salary, and then ordinary income on the remainder. It's a perk that sole-props don't have.

qb says: <<and I've never seen this "40%" as guidance in anything other than this comment in this topic,>>

I hadn't seen it until recently, when another client brought it up. Since then, I've seen it in a couple of places, like I said, among them IRS pages. I know the IRS website isn't 100% accurate, but I trust it more than pension companies. It may be a recent thing, which is why we old dogs haven't heard it. I'm still over here using an abacus.

qb asks: <<You can't throw out the generic word "pension." Is there a plan? What type of plan? How does this employee participate? What sort of account(s) does this person have?>>

Yes, it is a SIMPLE, and the employee contributes 1/2 from their own salary and 1/2 from the company assets. I didn't think I needed to get into the weeds on the specifics of the plan in this question, because "pension" covers multiple types of plans that all have similar rules, so I used the generic term.

qb says: <<Try thinking of this example: you hire a person and pay them $100k. Your entity has a $300k loss. What is your employee qualified to contribute to their "pension" plan, in your estimation?>>

That's a great example. The fact that she's the sole owner of the company doesn't change the fact that she is a W-2 employee with a stated salary enrolled in the pension plan. 

Thanks.

[BobKamman]

@ShoeBox Taxes "I've seen it in a couple of places, like I said, among them IRS pages."

No, you haven't.  But sometimes the pages blur into one continuous assault by the denizens of Artificial Intelligence world.  "Couple," to me, means "two."  "Among them IRS pages", to me, means more than one IRS page.  Let me assure you that you have not seen it on even one IRS page. 

Perhaps the 40% figure emerged on some report from IRS that noted, "40% of our S Corp audits involve companies that report no shareholder wages."  Because that's what IRS is looking at.  They don't have any method to select returns for audit based on "facts and circumstances" of each owner and each activity, because all that is developed during the audit.  The low-hanging fruit is, "we are coming after you because you didn't report any wages."  

[qbteachmt]

"and the employee contributes 1/2 from their own salary and 1/2 from the company assets. I didn't think I needed to get into the weeds on the specifics of the plan in this question, because "pension" covers multiple types of plans that all have similar rules, so I used the generic term."

No, details matter. Here's an example, right here in your topic:

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-simple-ira-contribu...

"Salary reduction contributions 

The amount an employee contributes from their salary to a SIMPLE IRA cannot exceed $16,000 in 2024 ($15,500 in 2023; $14,000 in 2022; $13,500 in 2020 and 2021; $13,000 in 2019 and $12,500 in 2015 – 2018).

If an employee participates in any other employer plan during the year and has elective salary reductions under those plans, the total amount of the salary reduction contributions that an employee can make to all the plans he or she participates in is limited to $23,000 in 2024 ($22,500 in 2023; $20,500 in 2022; $19,500 in 2020 and 2021 and $19,000 in 2019). See more than one plan.

• Catch-up contributions. If permitted by the SIMPLE IRA plan, participants who are age 50 or over at the end of the calendar year can also make catch-up contributions. The catch-up contribution limit for SIMPLE IRA plans is $3,500 in 2023 and 2024 ($3,000 in 2015 - 2022)."

That means your taxpayer contributes up to $19,000 for 2023 if over 50, all of this will be from Wages.

"Employer matching contributions

The employer is generally required to match each employee's salary reduction contributions on a dollar-for-dollar basis up to 3% of the employee's compensation. This requirement does not apply if the employer makes nonelective contributions instead.

• Lower percentage. An employer may choose to make a matching contribution less than 3%, but it must be at least 1% and for no more than 2 out of 5 years. See Notice 98-4 PDF for more information. The employer must notify the employees of the lower match within a reasonable period before the 60-day election period for the calendar year."

That means the Employer doesn't contribute more than 3%, or $2,970 on $99k salary.

I can't tell you the number of fights I have had with brokers setting up the accounts for SIMPLE IRA participants. Someone isn't administering this plan properly. They confused SEP-IRA and SIMPLE IRA, perhaps.

Yes, there are other plans that provide for what you described. These shareholder-employees are treated as self-employed for some things, as employee for others. But SIMPLE IRA is its own provision. It can be tricky:

https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people